Risk Versus Return
An important part of evaluating any investment is to consider the investment’s risk versus return. In general, you must be willing to take on higher risk to generate a higher return.
Likewise, if you want an investment with less risk, you can usually expect to receive a lower return.
For instance, we may think of money in bank checking accounts, savings accounts, and CDs as the least risky of all. They are not subject to market risks and, in the United States, are insured up to certain limits by the Federal Deposit Insurance Corporation. They are among the best places to keep money that is needed in the near future.
However, in keeping with the risk versus return concept, these types of bank accounts, while being the least risky, also provide the lowest return. In fact, in today’s financial environment, they may earn zero or close to zero percent of return.
Various Types of Risk
One type of risk that many investors fail to take into account is inflation risk. Inflation is simply the general increase in the price of goods and services. Due to inflation, a given amount of money will buy less in the future than it does today. So, even though there is virtually no risk of losing money in a savings account, it is not risk free because of the effects of inflation.
An investment in bonds is often thought of as a conservative type of investment. This can be true because of the promise of the issuer of the bonds to repay a set amount of interest to the investor. However, there are also some risks with bonds.
First of all, there is an interest rate risk. The value of a bond is somewhat determined by the amount of interest it pays out in relation to the current market interest rate. In general, in a time of rising market interest rates, the values of bonds decline. Likewise, in a time of declining market interest rates, the values of bonds increase. Because of interest rate risk, you may lose some of your investment if you need to sell a bond when the value has declined.
Another type of risk associated with bonds is default risk. If the company that issues a bond has financial difficulties, it may not be able to make a payment when it is due. The chances of this happening are more likely with a company issuing high yield or junk bonds. The greater chance of default translates into higher returns.
When investing in stocks, market risk is an important consideration. This is the risk that the market as a whole will decrease because of various factors. A specific stock may be susceptible to business risk. That is, the company itself may perform poorly.
There are also other types of risks to consider including liquidity, currency, valuation, and timing risks. The return of any particular investment may be affected by some or all of the various types of risks.
Managing Risk By Portfolio Diversification
Some of the types of risk can be somewhat decreased by following certain strategies. One such strategy is portfolio diversification. By spreading your money around between various companies and types of investments, declines in value in certain investments may be offset by returns in other investments. You may achieve some diversification through investment in mutual funds.
Before you invest, make sure you understand the various risks associated with each type of investment, your own tolerance for risk, your timeframe for investing, and the type of return you hope to receive.
A wise investor understands the concept of risk versus return and aims for the highest return possible given the investor’s tolerance for risk.
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